Plain English Investing in Bite-Size Pieces: All About Mutual Funds

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If you’ve contemplated some sort of investing, you’ve likely heard about mutual funds.  But if the idea of investing is new to you, or if you’ve never really studied investment options, mutual funds may be an unknown.  Here is a quick and dirty guide to the basics of mutual fund investing.

What is a mutual fund?

Think of a mutual fund as simply a basket.  It’s a basket full of individual securities.  A mutual fund might hold individual stocks, individual bonds, or some of both.  Funds can also hold other types of investments, but the main types that individual investors encounter are stock and bond mutual funds.

When you invest in a mutual fund, you are pooling your money with hundreds or thousands of other people.  A fund manager uses the money to buy the desired securities in the fund portfolio.

Why choose a mutual fund for investment?

Buying individual securities can be risky, especially if you are a smaller investor.  Mutual funds can hold anywhere from dozens to hundreds of different securities in them.  So, for example, if you have $10,000 to invest, you could buy ten individual stocks (investing $1000 into each).  Or, more efficiently, you could invest your $10,000 into a fund that owns hundreds of individual stocks.

Investing in mutual funds can decrease your risk because they are more diversified than owning individual securities.  Just be certain that you are not buying an ultra-risky mutual fund!  Stick with plain vanilla when it comes to choosing investments.

What are “load” and “no-load” funds?

A load is a fancy term for a commission.  There are two ways an investor can buy a mutual fund with the help of an advisor.  Some advisors get paid a commission for each transaction.  Therefore, if you buy a mutual fund through an advisor who works in this way, he or she will use a mutual fund with a load, or commission, to get compensated.

Other advisors are compensated on a fee basis instead of a commission basis.  In this case, since you are paying the advisor via a fee, the advisor would choose mutual funds with no load.

People often wonder if no load funds are always better to use than load funds, and I would answer, “not necessarily.”  What should matter to an investor is the performance of the funds chosen net after all fees and commissions.  In general, funds with a load will be more expensive than similar funds without a load.  But the proof, as they say, is in the pudding.  It is not always true that no-load funds perform better than load funds.

What are passively managed (index) funds and actively managed funds?

Other confusing terminology for new investors is passive versus active fund management.  In a passive, or index fund, the manager of the fund is not making any decisions about which securities to buy.  Rather, he or she is buying stocks or bonds in the companies that are represented in the corresponding index, in the same proportion.

You’ve probably heard of the S&P 500 Index.  This is an index of 500 of the largest publicly traded (i.e. you can buy their stock) companies.  The S&P is one of the indexes tracked to glean information about the behavior and performance of the overall stock market.  An S&P 500 Index fund would look and act just like the index itself, because the manager has purchased all the stocks in that index in exactly the same proportion.  Owning an S&P 500 index fund is like “owning the entire stock market,” or at least owning a piece of the entire market, in a sense.

Actively managed funds, on the other hand, involve a manager using some sort of selection framework to choose the stocks or bonds to buy inside his or her fund.  Since there is more work involved in running the fund, the cost to buy this sort of fund is often higher.

An often-touted statistic in the investment world is that 80% of actively managed funds consistently underperform their corresponding index fund.  This is likely true.  But that also means that 20% of the managers out there are consistently doing a better job than their corresponding index.  The challenge becomes knowing how to find those successful managers and monitoring their work to know they are maintaining their standing.

Bottom line

If you are doing your own investing instead of working with an advisor, I always recommend choosing no-load index funds.  The rationale is that not only are they the cheapest funds available, but also unless you are willing to consistently research and review your fund holdings, your risk of making a mistake is lower if you simply pick index funds.

If you are working with an advisor, be sure to inquire about his or her method for choosing the funds in your portfolio.  Make sure the method fits your risk tolerance and comfort level given your level of investing knowledge.  In other words, if you are not particularly savvy when it comes to knowledge of investments, stick with the basics – plain vanilla investments.

What questions do you have about mutual funds?  Feel free to share them below, or if you prefer, you can email me at Dawn@SimpleMoneyPro.com.  Or if you want to start a discussion with some like-minded friends, join the free SimpleMoney Community on Facebook to share your ideas!

You might also enjoy:

Plain English Investing in Bite-Size Pieces:  What the Heck are Stocks?

Plain English Investing in Bite-Size Pieces:  What the Heck are Bonds?

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